The Foreign Trust Policy of Income Assessment

The U.S. income tax results to a grantor (also referred to as a settlor, in foreign trusts) that creates a trust will differ, depending on whether the trust is classified as foreign or domestic. To be eligible of a foreign trust, a trust has to assure a two-part test. First, a U.S. Court must not be able to implement primary supervisions over the management of such trust. And second, one or more U.S. persons must not have the power to control all significant decisions connecting to the trust.

Once a trust is classified as a foreign trust using the above test, the taxation of the income of such a trust engrosses an advance determination as to whether it is a grantor trust (FGT) or a nongrantor trust (FNGT). An FNGT is one in which a U.S. person, 3 as grantor or settlor of the trust, has not maintained powers causing him to be treated as the owner of the trust for income tax purposes. To the extent that taxes are payable, the trust - not the grantor - pays. The grantor of an FNGT will not be treated as the owner of the trust if the trust is (1) irrevocable, (2) has no U.S. beneficiaries throughout the grantor's and grantor's spouse's lives, and (3) U.S. persons cannot accept distributions until one taxable year after the death of the grantor and grantor's spouse. Equally, a grantor trust is a trust in which the grantor is treated as the owner, and therefore the taxpayer, for the purposes of all income, deductions and credits of the trust. Put plainly, the foreign grantor trust becomes a sort of flow-through entity for income tax purposes resulting in all tax-paying liability being placed squarely on the grantor. The rules are valid only to income tax and not to gift or estate tax. These rules influence not only U.S. citizens but also U.S. residents and nonresidents. Certain fundamentals, if met, activate the application of the grantor trust rules.

The general rule is that at all time the grantor retains significant dominion and control over the trust, the burden of the tax on the trust's income remains with the grantor. In particular, the existence of the following circumstances results in constant income taxation of the grantor:

1. A reversionary interest in trust income or corpus, unless the interest is less than 5% of the value of that portion of the trust, in which the Grantor has the reversionary interest (in which case the interest will be ignored);
2. The rule to control beneficial enjoyment of the corpus or income of the trust;
3. Certain powers of administration, like the power to control the investment of the trust funds, which, if exercised, would primarily benefit the grantor and not the beneficiaries;
4. The power to revoke the trust; or
5. The power to accumulate or distribute income for grantor's benefit or for the benefit of the grantors spouse.

In spite of the above rules, if a U.S. person unswervingly or in some way transfers property to a foreign trust, which at any time during the transferor's taxable year has a U.S. beneficiary, such person, as transferor, will be reasoned the owner of the part of the trust attributable to that property, and will pay the gift tax on the transfer.